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Horngren'S Financial And Managerial Accounting
Found in: Page 1464

Short Answer

How is IRR calculated with unequal net cash inflows?

The after-tax cash flow for each period at time t is divided by some rate, r. The initial investment is then subtracted from the total of these discounted cash flows, yielding the present NPV. It is important to "reverse engineer" the value of r needed to make the NPV equal zero in order to determine the IRR.

See the step by step solution

Step by Step Solution

Step 1: Example

years

Net PV Present

Cash factor value

Inflow (i=16%)

Net PV Present

Cash factor value

Inflow (i=18%)

PV of each year’s inflow:

1 (n=1)

2 (n=2)

3 (n=3)

4 (n=4)

5 (n=5)

Total PV of cash inflows 0 Initial investment

NPV

$500,000 0.862 $431,000

350,000 0.743 260,000

300,000 0.641 192,300

250,000 0.552 138,000

40,000 0.476 19,000

(1,040,390)

1,000,000)

$40,390

$500,000 0.847 $431,000

350,000 0.718 251,300

300,000 0.609 182,700

250,000 0.516 129,000

40,000 0.437 17,000

(1,003,980)

(1,000,000)

$3,980

In this example for 1,000,000 initial investment in a project and these irregular cashflows we can conclude that IRR for this project is 18%.

Step 2: IRR advantage over NAV

NPV will be negative when IRR <cost of capital. Benefits: Since this strategy is expressed in percentage form, it is simple for financial managers to compare it to the necessary cost of capital.

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